FINANCING SOCIAL ECONOMY ORGANIZATIONS: RESEARCH RESULTS & POLICY RECOMMENDATIONS *

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1 Social Enterprise in Rural and Urban Development Dartmouth, Nova Scotia - March 25 & 26, 2010 FINANCING SOCIAL ECONOMY ORGANIZATIONS: RESEARCH RESULTS & POLICY RECOMMENDATIONS * George Karaphillis, Cape Breton University The study The study carried out over the last eighteen months focuses on the financing needs of organizations in the Social Economy in Atlantic Canada. The study aimed to complete a comprehensive survey of both the demand and supply of funds in the social economy. It examines the demand for external financing: it aims to identify financing needs and challenges facing a sample of social economy organizations, to determine characteristics of organizations that are successful in accessing external financing, and identify the factors affecting such success. It also examines the availability of funds from government, financial institutions, and foundations and the criteria used in assessing financing requests. The role of financing in enabling entrepreneurial activity and economic growth has been well recognized for years. It has been recognized that financing gaps are detrimental to the creation and growth of SMEs and governments have sponsored significant research on SME financing. Although the relative size of the Social Economy is larger in Canada than in other developed countries, governments in Canada have not shown comparable interest in SEO (Social Economy Organization) financing issues. The Atlantic research node of the Social Economy research suite believes there is great value in gaining insights on the financing issues affecting local SEOs. This research initiative was spurred by community partners, such as the Canadian Community Investment Network and the Saint John Community Loan Fund. There is agreement in the literature that the issues surrounding the financing of the social economy and how SEOs utilize and access external finance are central to the sustainability of the sector and the organizations therein. However, existing research has concentrated on the financing options and instruments available for SEOs. There has been little research on the demand and supply for external finance for SEOs, the uses of financing, and the challenges SEOs face in obtaining financing; for Canada in general and for Atlantic Canada in particular. There is also little research on the criteria used by financial institutions and government in providing financing. Scope The study used samples of social economy organizations and financial institutions within five geographical areas sufficiently restricted that we could enumerate the population of social economy organizations within it, namely Saint John NB, Cape Breton Island, Halifax regional municipality, Prince Edward Island, and Newfoundland. A sample was then drawn that included representatives of each organizational type of social economy organization, representatives of each sub-sector, and representatives from a variety of organizational size and age. This was followed by a survey of the majority of financial institutions and granting agencies in each community. The National Survey of Nonprofit and Voluntary Organizations reported that 13,000 incorporated organizations and registered charities operated in Atlantic Canada and they generate revenues of $5.7 billion 1. We have used a set of four accepted qualification criteria for Social Economy Organizations to narrow the list of organizations for our samples: economic activity, limited distribution of surpluses to members, voluntary association with legal and decisional autonomy, and democratic governance. 2 * Interim summary report. Please do not quote or cite without author permission. Research project is sponsored by:

2 Methodology The first phase of the study dealt with the demand for financing: survey focused on samples that include representatives of each organizational type of social economy organization, representatives of each sub-sector, and representatives from a variety of organizational size and age. The first major task in the research project was to determine the survey sample: to develop a database of SEOs in the target areas. There is no comprehensive database of SEOs in the region and the researchers spent a lot of time in assembling lists from different sources. In Saint John we benefited from the resources of the Human Services Council Saint John and the support and direct help of the Saint John Community Loan Fund. Newfoundland we benefited from the support and direct help of the Community Services Council. Our compiled list included over 5,000 organizations. By applying the four criteria described above, this listing was reduced to 1,142 SEOs, resulting in 281 completed surveys. The surveys include self-screening questions to ensure the respondent SEOs met the four qualifying criteria. Out of 281 responses, 207 met all four SEO criteria. The second phase of the study focused on the supply of finance and surveyed the financial institutions and granting agencies in each of the five geographical areas. Researchers compiled a list of 224 branches of financial institutions, government granting agencies, foundations etc. in the five study areas. Surveys were completed by 56 agents and officers of financial institutions and government agencies. Summary Profile of SEOs The majority of SEOs surveyed are small organizations: three quarters have fewer than 20 employees, with forty six percent having fewer than 5 employees. However, six percent of SEOs employ over 50 people! One third of organizations have a budget below $100,000, but half of the SEOs have an annual operating budget over $250,000, with one third surpassing the $500,000 level. The majority of organizations surveyed are well established: fifty nine of respondents have been established for over 20 years. SEOs mentioned sales of goods and services, grants, and donations as their primary sources of funds on an ongoing basis. The majority of SEOs (seventy seven percent) have pursued external financing. SEOs predominantly use grants, loans, and lines of credit for financing. The primary reason for external financing cited is to expand services, purchase a building, and purchase equipment. Financing assessment Lending officers of banks and credit unions overwhelmingly indicated that repayment capacity, security/collateral, credit history, management experience, and quality of the business plan are the most important factors considered in assessing loan applications in general. The survey also indicated that low profitability, lack of security and personal equity, reliance on grants, low financial expertise, and incomplete business plans were often encountered in loan applications from social enterprises. Only a quarter of bank officers indicated they could relax their lending criteria for community-owned organizations, as did fifty percent of credit union officers. However, seventy seven percent of CBDCs indicated they could relax the criteria for community organizations and apply preferential terms! Only a quarter of bank officers and forty five percent of financiers in general were aware of the term social economy; an even smaller minority were aware of the correct definition. Findings summary and Policy recommendations The study suggests there are a few gaps in financing organizations in the social economy, especially for startups. Rejection experienced for SEO financing is fairly high at forty two percent. There is heavy reliance on government grants: sixty percent of respondents had received grants in the previous twelve months and seventy four percent of SEOs planning an expansion are pursuing grants to finance the expansion! Interestingly, forty percent of SEOs are pursuing public/corporate fundraising for expansion also. This particular set of issues has been raised by a number of other researchers and practitioners in the past. However, there is now a raised awareness of the impact of the social economy in Canadian society and there appears to be some political will in making interventions. Paul Martin, former prime minister, is now involved in the social economy and the recent Speech from the Throne hinted that Canada is open to a bigger role for social enterprises. Policy interventions have the potential to make significant improvements:

3 Research finding #1: Majority of SEOs need to pursue commercial activity and external finance to grow, but restrictions in their legal organizational form are prohibitive. NFPs are not share-based and cannot access equity financing. The sector has to resort to dual organizational structures to be able to generate revenue and operate social enterprises in a sustainable manner. A few charities and NFPs have operated social enterprises as projects without fully understanding that they may be in default of their legal status: only 7% of respondents mentioned that legal restrictions did not allow external financing. Similar findings have been reported in the literature 3 Recommendation The time is now ripe for evaluating and introducing a legal form for SEOs that is similar to UK s Community Interest Company (CIC) or US s L3C; two different approaches, with UK s CIC allowing tax breaks and tax receipts. A new legal form will allow SEOs to become more entrepreneurial without having to create multiple cumbersome corporate structures. This will bring organizational efficiencies and savings and will facilitate growth. A recent report by the MaRS Centre is recommending this for the Province of Ontario 4. The Canada Revenue Agency has stated that their policy people are working on the concept of social enterprise 5. Research finding #2: SEO startups face major obstacles in accessing capital. Rejection experienced for SEO financing in general is fairly high at forty two percent of the Atlantic SEOs surveyed. The survey of financiers indicated their concern over security/collateral, personal guarantees, and lack of personal equity, in SEO financings. Mainstream SMEs face similar obstacles in securing startup financing; organizations in the social economy, with their multiple bottom-line mandate and additional organizational impediments, face a much bigger challenge. More than sixty percent of the financiers stated that typically SEOs low collateral, profitability, and revenue are very problematic. Reliance on donations and government grants and contracts also make SEO startups risky prospects for debt financing by mainstream lenders. More than thirty percent of financiers stated that SEOs heavy reliance on grants and government contracts was problematic; Twenty four percent of SEOs mentioned they were unsuccessful in obtaining financing because financial institutions do not finance social enterprises. In Quebec the presence of RISQ, a $10 million capital pool dedicated to social economy ventures fills this need to a great extent. Although there are some government-backed lending programs in the rest of Canada (CBDCs, Community Futures, etc.) that cater to the social economy for small loans, there is a gap for financings over $100,000. Recommendations Federal and provincial governments have a responsibility in enabling lending to SEOs. There is no SEO loan-guarantee program, like the federal CSBF program that is available to SMEs. A few provincial loan programs operate similarly but most are not available to SEOs either. There is no lending institution, besides the CBDCs, that accommodates the difficulty of securing personal guarantees on SEO loans, like the CSBF program does for SMEs. Studies indicate that the federal loan guarantee program has resulted in substantial total and incremental job creation in the mainstream economy 6, and will most probably have a similar, if not larger, effect in the social economy. Experiment with offering generous tax incentives to businesses and investors that wish to invest in startups in the social economy. Mainstream mid size businesses, corporate Canada, mutual funds, and wealthy investors may be interested in investing in venture capital pools that fund SEO startups; if they can benefit from tax credits similar to the ones offered to investments in junior exploration companies. This is an idea mentioned by a few potential investors and championed by Paul Martin, former minister of Finance and former Prime Minister. This development indicates that the concept is becoming acceptable to mainstream policy makers and it is attractive to mainstream venture investors; it has a high probability of significant uptake.

4 Evaluate the feasibility of ensuring that the instruments used for financing SEOs are fully compliant and registered with Canada s electronic capital markets. Enabling community funds (ex. CEDIFs) and venture capital pools to be listed in Canada s electronic fund system will provide enhanced credibility, make such investments mainstream, and increase accessibility to investors. A national approach to this project will most likely make it self-sustaining over a five-year period. It is well known that mainstream large national financial institutions do not invest/lend proportionally in the periphery. SMEs and SEOs located in peripheral regions find it more difficult to obtain financing. Canada should consider introducing legislation similar to US s Community Reinvestment Act (CRA). This legislation would require that financial institutions do lend/invest to SMEs and SEOs in each community they operate in. CRA has been criticized as contributing to the financial meltdown of 2008, but Canada has a mature and conservative banking sector that knows how to manage risk; the likelihood that the minimal community investments would weaken the banking system is very small. Research finding #3: Many SEOs have expansion plans that require sizeable financing. A large percentage of the Atlantic SEOs surveyed (forty two percent) plan to expand or start a new venture. They are reporting that they require large amounts of financing: a quarter of the growing SEOs require funds in excess of $500,000 for expansion. It is understood that projects in the housing, real estate, healthcare, green energy, and hospitality sector are capital intensive and require large size investments, However, lass than twelve percent of SEOs have raised this level in the previous twelve months, indicating a funding shortfall is in the offing, Recommendations: There is need to develop stable patient capital pools, that could operate like bond funds and will lend to mature SEOs for expansion. Should support the concept of a community capital program, with assistance for regional loan pooling and a government guarantee. Regional capital pools may work better as they offer some geographic and company diversification to the investors. This may appeal to foundations and other Socially Responsible Investment (SRI) organizations as a good investment vehicle. The Canadian Alternative Investment Co-Operative, Toronto, is an example of a pool that invests nationally, but the concept would evolve into faster growing regional pools with the help of a partial government guarantee. Provincial governments should initiate discussions with labour unions and consider partnering with labour on a capital pool dedicated to funding social enterprises, in the model of the Fiducie du Chantier de l Economie Social. This is obviously not easily duplicated: the creation of the Chantier has been in the making since 1996 and Quebec has a unique socioeconomic culture and a labor movement that is committed to the social economy and the environment. The Chantier has assets exceeding $50 million and has invested over $6 million in social enterprises. 7 Some provinces may have the right climate in place for such collaboration. Regarding housing investments, unionized labour funds have collaborated on a real estate development company, Concert Properties, aimed at providing low priced rental housing; they have constructed over 8,000 units since It is conceivable that a small public investment may leverage large investments for expansion of social enterprises that target sectors favoured by the labour pension funds. Tax incentives should be offered to all Canadians who wish to invest in the social economy, especially through the convenient and popular RRSP vehicle. The RRSP eligibility of Nova Scotia s Community Economic Development Investment Funds (CEDIFs), coupled with the 35% Nova Scotia tax credit makes it a successful model: it facilitates the use of equity financing by SEOs, from investors using their RRSP savings. Considering the risk-averse nature of RRSP investments, this route would be best used by mature SEOs. Over $33 million have been raised to-date by CEDIFs, with a sizable portion being invested in SEO and green energy startups and expansions. The Province of PEI is adopting this model and it is expected that CEDIFs will be available to PEI citizens next fiscal year.

5 Research finding #4: Community organizations typically have low financial and management expertise and submit incomplete business plans. Fifteen percent of surveyed SEOs mentioned) that the quality of their business plan document was one of the reasons they did not succeed in obtaining financing. In addition, over forty percent of the surveyed providers of finance stated that SEOs typically submit incomplete business plans and have low financial expertise. Thirty one of the surveyed providers also stated they had concerns over the management of SEOs. There is obviously a gap in management capacity within the SEO sector. The federal government has provided support for capacity building in the co-operative sector, through the Co-operative Development Initiative. In Quebec, Labour has partnered with the provincial government and offers extensive capacity building services to the social economy via CSMO-ESAC; an organization mandated to the development of human resources for the social economy. There is no systematic programming to build human resources for the whole social economy in the rest of Canada. Recommendations: 1. Federal and provincial governments should consider investing in SEO capacity building by: o o Investing in human resource development and training programs Subsidizing salary of business professionals seconded to help growing SEOs 2. Governments should provide business support, customized to the needs of the social economy. This will help increase investment readiness and create demand for external financing. Government agencies mandated for economic development should offer support for professionals; to work with SEOs in developing business plans. Governments should also support feasibility studies on SEO business plans and should fund proof of concept. 1 Rowe, P. (2006), The Nonprofit and Voluntary Sector in Atlantic Canada, Imagine Canada, Toronto 2 Bouchard, M. J., Ferraton, C., & Michaud, V. (2006). Database on social economy organizations: The qualification criteria. Chaire de recherche du Canada en economie sociale, Research Series No R , Universite du Quebec a Montreal 3 Corriveau, S. (2010). The fine print: Vital information for Canadian charities operating social enterprises. Available: accessed on February 5, Hewitt, A., Convery M. and Chung W. (2010), Social Entrepreneurship: Legislative innovations, Social entrepreneurship white paper series, MaRS Centre, Toronto 5 Wingrove, J. (2010). The Right Brothers, Globe and Mail, 20 March 2010: F1+ 6 Riding, A.L., & George Haines, G. Jr. (2001). Loan guarantees: Costs of default and benefits to small firms. Journal of Business Venturing, 6, Mendell, M., (2008) The three pillars of the social economy: the Quebec experience ( ), in Amin. A. (Eds), The Social Economy, International Perspectives, Zed Press, London 8 Mook, L. (2009), Financing in Quarter J., Mook L, & Armstrong A. (Eds.), Understanding the Social Economy: A Canadian Perspective, University of Toronto Press